Incremental analysis is used to find the impact of changes in costs or revenues, given a specific potential scenario.

Decisions involving incremental analysis include the following: Make or buy: Should we make a component ourselves or farm out the work to someone else? Qualitative considerations may or may not override quantitative issues. For example, we may be able to subcontract work more economically than we can do it ourselves, but if the contractor is unable to maintain the necessary level of quality or meet delivery schedules, subcontracting may not be worthwhile. The impact of quality and/or delivery problems may not be quantifiable, thus making the whole business a judgment call. Sell or process further: Sell or process further issues often arise in industries which refine raw materials. The key question is whether the incremental revenues from a more highly refined product will at least offset the increased costs associated with additional processing. Special order: Special orders typically involve special requests from customers who want a reduced price or some sort of special work. The extra effort might take the form of extra machining, special finishes, rush delivery [which could entail both an accelerated production schedule as well as air freight or other transportation costs], or an unusually small production run. As with the other decisions discussed here, quantitative and qualitative issues may be in conflict. Suppose an especially valuable customer want some sort of special deal, whether a reduced price or extra work. The lower revenue or added costs may mean taking a loss on the job, but we have to decide whether alienating the customer is more serious than the short term hit on profits. Some costs associated with special orders are not easily accounted for. Special production runs may require extra set ups of machinery which increase total indirect costs; however, such costs are often not easily accounted for, and therefore may not be readily added to the charges to the customer, even if the customer is willing to absorb such charges. Changes in production and/or technology: Modifications in production processes or acquisition of new machinery typically entail adjustments in costs. New machinery or a revised process may enhance efficiency in the use of labor and/or material. It is clearly important to know whether the improvements offset whatever incremental costs may be associated with the changes. It is obviously important to be able to understand how decisions like these affect both fixed and variable costs. If a given costs element does not change with a particular decision, it is irrelevant for purposes of that decision and we can ignore it. This may simplify calculations. For example, if the only change due to a decision is an increase or decrease in variable costs, all we need to do is recalculate the contribution margin.

A question of relevance The basic concept underlying almost all incremental analyses is the idea of relevance: What revenues and/or costs are relevant to the decision in question? In

many situations requiring incremental analysis, fixed costs remain unchanged, irrespective of the course of action finally taken. Therefore, those fixed costs are irrelevant for the purposes of the decision in question and can be ignored. [This is not to say that fixed costs are unimportant, or that they don't eventually have to be taken into account. In the long run, fixed costs have to be covered if we are going to make money.] However, incremental analysis is typically used for short run, one-time decisions. When "one-time decisions" get to be routine, it may be time to reevaluate the situation. For example, suppose a customer wants some sort of special attachment on a product-what on the surface appears to be a "this month only" occurrence. Then perhaps two or three months later, the same customer calls and says "Remember back in May you did a special job for us? Well, we need another thousand of those. How soon could you have them?" At some point, management needs to determine whether the "one-time occurrence" has suddenly become the "normal circumstances." Another key element in incremental analysis is the notion of sunk costs. Sunk costs are costs which were incurred in the past. No future action or inaction can change the situation. Suppose we spend a million dollars on June 1st for a large machine which will enhance productivity. On June 2nd, a sales representative offers to sell us a competitive machine for $500,000; this machine has twice the productivity of the one purchased on June 1st. In this classic case of "buyer's remorse," it is tempting to we now have a $1.5 million decision. However, the million spent on machine #1 is a sunk cost. We may have really messed up by not doing our homework and surveying all the options available before we bought the machine. However, if the second machine really will have the stated impact on productivity, it would be foolish not to spend the money [if we have, of course; we may have "shot our wad" on machine #1]. However, no matter what we do, the million is gone and is irrelevant to the decision about machine #2.

Introduction to Incremental Analysis

Managerial decisions are choices made based on financial and nonfinancial information. Typically, financial information serves as the first hurdle in identifying a possible course of action as an alternative. If the financial hurdle is met, then management must consider the impact of the alternative on the environment, the company's employees, its image, the community, its partners or alliances, and so on before making a final decision. Incremental analysis, sometimes called marginal or differential analysis, is used to analyze the financial information needed for decision making. It identifies the relevant revenues and/or costs of each alternative and the expected impact of the alternative on future income. To illustrate the concept, think about the decision to lease or buy a car. Leasing involves a regular payment and the return of the vehicle at the end of the lease unless a one-time payment is made. This arrangement means the car does not legally belong to the person leasing it. To buy a car requires payment of the purchase price. The payment may be made in cash or by signing a note payable for the amount owed. If you were to prepare financial statements under each alternative, they would look very different. An operating lease for a car with payments of $300 per month would result in the annual cost of the lease, $3,600, being reported as an expense on the income statement. The purchase of a car results in an asset and a liability, if a note was signed being recorded on the company's balance sheet. Another example is the choice between alternatives A and B, given the following relevant revenues and expenses:

Alternative A Alternative B Net Income Increase/(Decrease) Revenues Expenses $ 22,000 Net Income
This example shows alternative B generates $23,000 more net income than alternative A. Management must now consider the nonfinancial information to determine whether alternative B should be accepted. Several concepts are incorporated into incremental analysis and need to be defined before discussing some specific applications of incremental analysis.

$100,000 78,000

$150,000 105,000 $ 45,000

$50,000 (27,000) $23,000

Relevant cost. Those revenues and costs that differ among alternatives, as opposed to revenues and costs that stay the same, which are ignored when analyzing alternatives. Note: Some texts refer to the revenues that change as relevant benefits. Sunk cost. A cost that has already been incurred and, therefore, has no impact on future decisions because the cost will not change or go away in the future. The book value of a previously purchased and currently owned asset will not change whether or not a new asset is purchased to replace it. Opportunity cost. A potential benefit that is lost when a company chooses another alternative.

Examples of Incremental Analysis

Incremental analysis, sometimes called marginal or differential analysis, is used to analyze the financial information needed for decision making. It identifies the relevant revenues and/or costs of each alternative and the expected impact of the alternative on future income. Here are some examples of incremental analysis:

Accepting additional business. Making or buying parts or products. Selling products or processing them further. Eliminating a segment. Allocating scarce resources (sales mix).

Accepting additional business

The Party Connection prepares complete party kits for various types of celebrations. It is currently operating at 75% of its capacity. It costs The Party Connection $4.50 to make a packet that it sells for $25.00. It currently makes and sells 84,000 packets per year. Detailed information follows:

Per Unit Annual Total $25.00 $2,100,000 Sales Direct Materials Direct Labor 12.00 6.00 1,008,000 504,000

Overhead Selling Expenses Administrative Expenses

.50 1.75 .25 20.50

42,000 147,000 21,000 1,722,000 $378,000

Total Costs and Expenses $ 4.50 Operating Income

The Party Connection has received a special order request for 15,000 packets at a price of $20 per packet to be shipped overseas. This transaction would not affect the company's current business. If 84,000 packets is 75% of capacity, 112,000 packets would be 100% of capacity. The Party Connection has the capacity to prepare the 15,000 packets requested without changing its existing operations. Should the Party Connection accept this special order? Using its current cost information, the answer would be no because accepting the order would generate a $7,500 loss.

Per Unit Total $20.00 $300,000 Sales Direct Materials Direct Labor Overhead Selling Expenses Administrative Expenses 20.50 Total Costs and Expenses $ (.50) Operating Income $(7,500) 307,500 12.00 6.00 .50 1.75 .25 180,000 90,000 7,500 26,250 3,750

However, this is not the proper way to analyze the alternative. Incremental analysis, which identifies only those revenues and costs that change if the order were accepted, should be used to analyze the alternative. This requires a review of the costs. Suppose the following information is discovered with further analysis:

Accepting this order would not impact current sales. To manufacture 15,000 packets would require $12.00 of direct materials and $6.00 of direct labor. The per unit overhead cost of $0.50 is 50% variable ($0.25) and 50% fixed ($0.25). Selling costs (includes commissions and delivery costs) for the 15,000 packets would be $7,000. Administrative expenses would not change.

Per Unit Totals $20.00 $300,000 Sales Direct Materials Direct Labor Overhead Selling Expenses Total Costs and Expenses $19,250 Operating Income
Under this scenario, $300,000 of additional revenues would be created with additional costs of $280,750, so operating income would increase by $19,250 if the order were accepted. Given the available capacity, this opportunity would not result in additional costs to expand capacity. If the current capacity were unable to handle the special request, any new costs for expanding capacity would be included in the analysis. Also, if current sales were impacted by this order, then the lost contribution margin would be considered an opportunity cost for this alternative. With additional operating income of $19,250, this order could be accepted.

12.00 6.00 .25

180,000 90,000 3,750 7,000 280,750

Making or buying component parts or products

The decision to make or buy component parts also uses incremental analysis to determine the relevant costs. Opportunity costs must also be considered. Toyland Treasures uses part #56 in several of its products. Toyland Treasures currently produces 50,000 of part #56 using $0.30 of direct materials, $0.20 of direct labor, and $0.10 of overhead. The purchase of parts is under review by the company's management. Purchasing has determined it would cost $0.75 per unit to purchase 50,000 of part #56. Should Toyland Treasures continue to make part #56 or should it purchase the part? The total costs to produce part #56 are $30,000, a savings of $7,500 over the purchase option, and the choice would be for Toyland Treasures to continue to make the part.

Make Purchase ($0.75) Direct Materials ($.30) $15,000 Direct Labor ($0.20) Overhead ($0.10) 10,000 5,000

Buy $37,500

Incremental Increase/(Decrease) $(37,500) 15,000 10,000 5,000 $ (7,500)

$30,000 $37,500 Total Relevant Costs

If Toyland Treasures can use the part #56 production space for a product that would generate $20,000 of additional operating income, the make or buy analysis would generate incremental costs of $12,500 to make the part. In this case, the company would likely choose to purchase part #56 and produce the other product. The $20,000 additional operating income is considered an opportunity cost and is added to the Make column of the analysis.

Make

Buy

Incremental Increase/(Decrease) $(7,500) 20,000 $12,500

Total Relevant Costs $30,000 $37,500 20,000 Opportunity Cost $50,000 $37,500 Total Costs

Selling products or processing further

Some companies' product can be sold at different stages in their production cycle. For example, the DGK Company manufactures children's play gyms. It can sell the gyms assembled or unassembled. Incremental analysis is used in the decision to sell unassembled products. A general guideline DGK should consider when deciding how to sell its units is that if the incremental revenues generated from assembling the gyms are greater than the incremental assembly costs, DGK should assemble the gyms (process further). DGK sells an unassembled gym for $1,000. Its costs to manufacture a gym are $550, which consist of direct materials of $300, direct labor of $150, and overhead of $100. It is estimated that assembling a gym would take additional labor of $100 and overhead of $25, and once assembled, the gym could be sold for $1,500.

Sell (Unassembled) $1,000 Revenue Costs Direct Labor Overhead 550 Total Costs $ 450 Operating Income 300 150 100

Process Further (Assembled) $1,500

Operating Income Increase/(Decrease) $500

300 250 125 675 $ 825

0 (100) (25) (125) $375

On a per unit basis, the incremental analysis shows that DGK should process further and assemble the gyms. Qualitative factors such as loss of business if unassembled gyms were not offered (an opportunity cost) and customers' willingness to pay the additional $500 for an assembled gym need to be considered. An alternative way of analyzing this decision is:

Bases, Inc. Manufacturing Overhead Budget 20X1 An alternative way of analyzing this decision is: Sales Price if Process Further (assembled) $1,500

1,000 Sales Price if Sell (unassembled) Incremental Revenue Costs to Process Further Direct Labor Overhead 125 Total Costs to Process $ 375 Incremental Operating Income $100 25 500

Eliminating an unprofitable segment

If a company has several business segments, one of which is unprofitable, management must decide what to do with the unprofitable segment. In reviewing the quantitative information, a distinction must be made between those costs that will no longer exist if the segment ceases to do business and those costs that will continue and need to be covered by the remaining segments. Costs that go away if the segment no longer operates are called avoidable costs, and those that remain even if the segment is discontinued are called unavoidable costs. Segment data for See Me Binoculars, Inc., shows the economy segment has operating income of $120,000, the standard segment has operating income of $250,000, and the deluxe segment is unprofitable by $200,000. The total company has operating income of $170,000.

See Me Binoculars, Inc. Segment Income Statement 20X0 Economy Standard Deluxe Revenues Variable Expense Contribution Margin 300,000 500,000 300,000

Total

$1,200,000 $1,500,000 $2,500,000 $5,200,000 900,000 1,000,000 2,200,000 4,100,000

1,100,000

180,000 Fixed Expenses $120,000 Operating Income

250,000 $250,000

500,000

930,000

$ (200,000) $170,000a

To prepare the quantitative analysis for its decision whether to eliminate the deluxe segment, the fixed expenses must be separated into avoidable and unavoidable costs. It has been determined that unavoidable costs will be allocated 45% to economy and 55% to standard. If all the fixed expenses are unavoidable, the company would experience an operating loss of $130,000 if the deluxe segment was discontinued, split as follows:

Economy Revenues Variable Expense Contribution Margin 300,000 405,000 * Fixed Expenses

Standard

Total

$1,200,000 $1,500,000 $2,700,000 900,000 1,000,000 1,900,000

500,000 525,000 **

800,000 930,000

$ (105,000) $ (25,000) $ (130,000) Operating Loss

If $300,000 of the fixed expenses are avoidable costs and $200,000 are unavoidable costs, the company's operating income would remain unchanged at $170,000.

Economy Revenues Variable Expense Contribution Margin 300,000 270,000 * Fixed Expenses $ 30,000 Operating Loss

Standard

Total

$1,200,000 $1,500,000 $2,700,000 900,000 1,000,000 1,900,000

500,000 360,000 ** $ 140,000

800,000 630,000 $ 170,000

The deluxe model has a contribution margin of $300,000, which helps cover some but not all of the fixed expenses generated by its production and the fixed corporate expenses that are allocated to it. If the unavoidable expenses (variable and fixed) are more than the segment's revenues, a decision should be made as to whether to discontinue the segment. If the avoidable expenses are less than the segment's revenues, discontinuing the segment could result in a loss to the company. Although a segment may be unprofitable, it may be contributing to the overall income of the company. This and other factors should be considered before discontinuing the segment.

Allocating scarce resources (sales mix)

When a company sells more than one product and has limited capacity for production of its products, it should optimize its production to produce the highest net income possible. To maximize profit, a calculation of the contribution margin for each product is required. In addition, the amount of the limited capacity each product uses must be determined. For example, if Golfers Paradise produces two different sets of golf clubs, it is limited by its machine capacity of 4,200 hours per month. The relevant data needed to determine production requirements are contribution margin and machine hours required to produce the standard and the deluxe set of golf clubs.

Standard Set Deluxe Set Contribution Margin $150 $270 1.5

Machine Hours per Set .75

From the relevant data, the deluxe set appears to have the largest contribution margin. However, the standard set can be produced in half the time it takes to produce the deluxe set. To determine which unit should be produced, the contribution margin per hour (the limited resource) must be determined. It is calculated by dividing the contribution margin by the machine hours per set. This calculation shows the standard set has the highest contribution margin when the capacity limitation is considered. The company should produce the standard set.

Standard Set Deluxe Set Contribution Margin Machine Hours per Set $150 .75 $270 1.5 $180

Contribution Margin per Hour $200

If both sets required the same machine hours, the deluxe set would be produced. If the market for the standard set is less than 67,200 (the number of standard sets that could be produced in a year), the deluxe sets should be produced for any excess capacity remaining after the standard sets are produced.

What Does Incremental Analysis Mean? A decision-making technique used in business to determine the true cost difference between alternatives. Incremental analysis ignores sunk costs and costs that are the same between the two alternatives to look only at the remaining costs. For this reason, it is also called the "relevant cost approach," "marginal analysis" or "differential analysis." Investopedia explains Incremental Analysis

If a company is considering replacing its old copy machine, using incremental analysis, the company would not look at the cost of the existing copy machine because it is a sunk cost (the cost of buying it cannot be reversed). They would look at things like the cost of toner cartridges for each machine, the cost of the electricity run each machine, and most importantly, the time saved by having employees use a more efficient model and perhaps the cost savings of being able to prepare documents in-house instead of outsourcing them.

Chapter 11 Incremental Analysis

This chapter addresses incremental analysis which is a simplified approach to a number of different short-term decisions that managers must often make. A number of specific management decisions will be introduced in a later chapter, however this chapter is devoted to the overall concept of incremental analysis that will use as a part of capital budgeting.

Decision Components

Decision-making involves choosing between alternatives. The focus of incremental analysis is to examine what is different between the alternatives in terms of three major amounts:
123Revenue differences (often called benefits) Cost differences Cost savings differences

Incremental amounts are often called differential or relevant, however thinking of incremental amounts as 'what is different' will help you identify them more quickly. Incremental analysisrelies on cost behavior concepts which separates costs into variable and fixed components so that managers can anticipate how each cost will behave in the future.

Why Use Incremental Analysis? Managers typically make decisions by selecting between at least two alternatives. Because there is often a lot data and information available, a manager's time is used more effectively if he or she examines only the amounts that differ between the decisions. These differences are the only RELEVANT amounts that are needed to make a decision because no matter what decision a manager makes, non-relevant amounts stay the same because they do not differ between the alternatives. One option managers sometimes use in decision-making is to create budgeted, side-by-side income statements that list the total revenues and total costs to be incurred under each decision outcome. However, because many costs are the same regardless of which decision is made, it is preferable, and much more efficient for managers to concentrate on only the relevant amounts. It is fruitless to waste time on irrelevant amounts when incremental analysis identifies the same decision choice.

Deciding What is Relevant and What is Not Relevant The easist way to think about costs when deciding are they relevant or not is to set up two column and label each with the respective decision alternative. For example, a manager is deciding whether to buy a new delivery truck or keep the old truck. The first column could be labeled as 'Keep Old Truck', and the second column could be labeled as 'Buy New Truck.' Under each column label, list the total costs and revenues under each situation. The costs that are the same under both alternatives are not relevant and can be ignored in the analysis. The costs that differ are relevant and should be used in the analysis.

Opportunity costs are always relevant because they represent the benefit given up as a result of choosing one option over the other. While they are not cash outlays, the represent an increase in profit for one decision over the other. Sunk costs are never relevant because they have already occurred and cannot be changed no matter which decision option is chosen.

How to Perform Incremental Analysis The following steps should be performed to create an incremental analysis: Step 1: Compare revenues under both alternatives. Revenues that change are relevant. Revenues that do not change are not relevant. Eliminate all irrelevant amounts. If possible, list on the differences.
Assume that AT, Inc. plans to produce and sell 80,000 calculators next year to be sold at $7 each. Management is considering raising the selling price to $8 per unit, but this is likely to cause the sales volume to drop to 76,000 units. Since both units and selling price will change, you must consider both changes as part of the incremental revenue. The incremental approach determines the difference between old and new revenue: Original revenue: 80,000 x $7 Adjusted revenue: 76,000 x $8 Incremental revenue $560,000 608,000 $48,000

Step 2: Compare costs under both alternatives. Costs that do not change are not relevant. Eliminate all irrelevant amounts, including sunk costs. List only costs that change because they are the only costs that are relevant. Assume that the variable cost per unit is $4 for AT, Inc. and fixed costs are $100,000. The relevant variable cost is the difference between the total variable costs in both alternatives. There will be a cost savings for variable costs because fewer units will be sold. Because fixed costs remain the same at all levels of activity, there is no change to fixed costs. Step 3: Separate relevant costs into variable and fixed categories and determine the differences of each. The relevant variable cost is $4 per unit. The number of units will decrease given that 4,000 fewer units (80,000 - 76,000) will be sold. Instead of additional costs, there will be a cost savings:

Variable cost savings: (80,000 - 76,000) x $4

$16,000

Step 4: List and clearly label each incremental revenue, incremental cost, and incremental cost savings. Include a + sign if the incremental amount increases profit (i.e., a benefit). Show the amount in ( ) parentheses if profit will decline. Note that a decrease in costs causes an increase in profits, so the amount should be added to reflect the increase in profit. Total up the amounts. If the result is positive (incremental revenues exceed the incremental costs), profit increases, so the decision should be accepted. If the result is negative (incremental revenues are less than incremental costs), profit decreases, so do not accept.

Original revenue: 80,000 x $7 Adjusted revenue: 76,000 x $8

$560,000 608,000

Incremental revenue Variable cost savings: (80,000 - 76,000) x $4 Incremental increase in profit

+$48,000 + 16,000 +$64,000

The net effect of the changes is an increase in profit of $64,000. Note that the incremental analysis did not determine the total profit under either alternative. Only the relevant amounts were considered.

Qualitative Issues Qualitative effects (nonfinancial amounts) must be considered regardless, but should not be the sole basis for decision.

Walk-Thru Problem #1
Walker Company sells hammers. During the past year, 4,000 hammers were produced and sold at $20 each. Variable cost per unit was $9 and total fixed costs were $32,000. Walker would like to change the selling price per hammer to $19 each, and feels that this will increase sales to 4,600 hammers per year. Which costs are not relevant and why? How much is the incremental revenue? How much is the incremental profit?

Solution: Fixed costs are not relevant since the amount stays the same regardless of whether the selling price stays at $20, or is reduced to $19. Incremental revenue is: Incremental revenue: (4,600 x $19) $7,400 (4,000 x $20) Incremental profit is the difference between incremental revenue and incremental costs. Only variable costs are relevant because fixed costs stay the same in total no matter what decision is made. Incremental revenue +$7,400 Incremental cost: (4,600 - 4,000) x $9 (5,400) Incremental increase in profit +$2,000

Walk-Thru Problem #2 Dons Donuts budgets the following costs for the production of 36,000 boxes of donuts next year: Rent, $20,000; other fixed costs, $6,000; materials, $54,000, and hourly labor,

$36,000. The normal selling price is $4.00 per box. A new convenience store has offered to pay Dons $3.00 per box to supply them with 10,000 boxes of donuts during the year. Assuming that Dons has the capacity to fill this order along with their other production and that accepting this order will not cause problems with any of their other customers, should Dons Donuts sell th 10,000 boxes to the cops? Justify your answer with computations. Solution: First determine incremental revenue:

+ $30,000 If the order is accepted, revenue increases by $30,000 due to the increase of 10,000 boxes sold at $3 per box. Incremental cost is based on the only the change in variable costs since fixed cost remain the same in total no matter how many boxes of donuts are sold. Total variable cost is $54,000 plus $36,000, or $90,000 when 36,000 boxes of donuts are produced and sold. The unit variable cost is $90,000 divided by 36,000 boxes for a cost of $2.50 per box. The analysis should appear as follows: + Incremental revenue ($3.00 x 10,000) $30,000 Incremental cost: $2.50 x 10,000 boxes (25,000) Incremental increase in profit + $ 5,000 Incremental revenue ($3.00 x 10,000)

Because costs increase, profit drops. When profit declines, parentheses are placed around the amount to show the effect on profit.
Yes, Don's Donuts should sell the additional boxes because incremental profits will increase by $5,000.

Cost Classification for Decision Making (Decision Making Costs):

Learning objective of this article:
Define, explain, and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.

Costs can be classified for decision making. Costs are important feature of many business decisions. For the purpose of decision making, costs are usually classified as differential cost, opportunity cost, and sunk cost. It is essential to have a firm grasp of the concepts differential cost & differential revenue, opportunity cost, and sunk cost.

Differential Cost and Differential Revenue:

Definition and Explanation of Differential Cost and Differential Revenue:

Decisions involve choosing between alternatives. In business, each alternative will have certain costs and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in cost between any two alternatives is known as differential cost. A difference in revenue between any two alternatives is known as differential revenues. Differential cost includes both cost increase (incremental cost) and cost decrease (decremental cost). In general the difference (cost and revenue) between alternatives are relevant in decision making. Those items that are the same under all alternatives can be ignored. The accountant's differential cost concept can be compared to the economist's marginal costconcept. In speaking of changes in cost and revenue, the economists employ the term marginal cost and marginal revenue. The revenue that can be obtained from selling one more unit of product is called marginal revenue, and the cost involved in producing one more unit of a product is called marginal cost. The economists marginal cost is basically the same as the accountant's differential concept applied to a single unit of out put.

Example:
Differential cost can be either variable or fixed. To illustrate assume that a company is thinking about changing its marketing method from distribution through retailers to distribution by door to door direct sale. Present cost and revenues are compared to projected costs and revenues in the following table.
Description Revenue (variable) Retailer Distribution (Present) $700,000 --------Cost of goods sold (V) Advertising (V) Commissions (F)* Warehouse depreciation (V)** Other Expenses (F) 350,000 80,000 -050,000 60,000 ---------Total 540,000 ---------Net Operating Income $160,000 ======= Direct Sale Distribution (Proposed) $800,000 --------400,000 45,000 40,000 80,000 60,000 ---------625,000 ---------$175,000 ======= Differential Costs and Revenues $100,000 --------50,000 (35000) 40,000 30,000 -0---------85,000 ---------$15,000 =======

*F = Fixed **V = Variable

According to the above analysis, the differential revenue is $100,000 and the differential cost is $85,000,leaving a positive differential net operating income of $15,000 under the proposed marketing plan. The net operating income under the present distribution is $160,000, whereas the net operating income under door to door direct selling is estimated to be $175,000. Therefore the door to door direct distribution method is preferred, since it

would result in $15,000 higher net operating income. Note that we would have arrive at exactly the same conclusion by simply focusing on the differential revenue, differential cost, and differential net operating income, which also shows a net operating advantage of $15,000 for the direct selling method. The company can ignore other expenses of $60,000. Because it has no effect on the decision. If it were removed from the calculation, the door to door selling method would still be preferred by $15,000. This is an extremely important principle in management accounting.

Opportunity Cost:
Definition:
Opportunity cost is the potential benefit that is given up when one alternative is selected over another. To illustrate this important concept, consider the following examples:

Example 1:
Vicki has a part-time job that pays her $200 per week while attending college. She would like to spend a week at the beach during spring break, and her employer has agreed to give her the time off, but without pay. The $200 in lost wages would be an opportunity cost of taking week off to be at the beach.

Example 2:
Suppose that Neiman Marcus is considering investing a large sum of money in land that may be a site for future store. Rather than invest the funds in land, the company could invest the funds in high-grade securities. If the land is acquired, the opportunity cost will be the investment income that could have been realized if the securities had been purchased instead.

Example 3:
You are employed in a company that pays you $30,000 per year. You are thinking about leaving the company and returning to school. Since returning to school would require that you give up $30,000 salary. The forgone salary would be an opportunity cost of seeking further education. Opportunity cost is not usually entered in the accounting records of an organization, but it is a cost that must be explicitly considered in every decision a manager makes. Virtually every alternative has some opportunity cost attached to it.

Sunk Cost:
Definition:
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in future.

Example:
Sunk costs cannot be changed by any decision. These are not differential costs and should be ignored in decision making. To illustrate a sunk cost, assume that a company paid $50,000 several years ago for a special purpose machine. The machine was used to make a product that is now obsolete and is no longer being sold. Even though in hindsight the purchase of the machine may have been unwise, no amount of regret can undo that decision. And it would be folly to continue making the obsolete product to recover the original cost of the machine. In short, the $50,000 originally paid for the machine has already been incurred and cannot be differential cost in any future decision. For this reason, such costs are said to be sunk costs and should be ignored in decision making.